How to perform a Return On Equity calculation, and ROE analysis?
This example takes you through the 2017 results of Apple Inc, and shows you both the math
as well as the interpretation of the numbers.
Stick around for the full discussion, as things become very interesting when you start to
attach meaning to the numbers!
What is the "high level" formula for Return On Equity?
Net Income divided by Equity.
To find Net Income, you need to check the bottom line of the income statement.
48 billion dollar for Apple in fiscal 2017.
To find the Equity number, you need to turn to the right-hand side of the balance sheet.
Usually, the average of the starting and the ending Equity number of the year is used,
in the case of Apple 131 billion dollar.
You divide the two numbers, and there's your ROE number of 37% for 2017.
But what is driving that performance?
What are its components?
That's where the DuPont formula and DuPont analysis come in!
The three step DuPont ROE formula takes the "high level" calculation
and splits it into three sections.
Net Income over Sales, or Return On Sales.
Sales over Assets, or Asset Turnover.
Assets over Equity, or Leverage.
As you see, Sales is both in the numerator as well as the denominator of the equation,
so would disappear in the multiplication.
The same goes for Assets, which is also in both the numerator as well as the denominator
of the equation.
For analytical purposes, having the three sections is very useful, as you will soon see.
Let's visit the income statement again, to find the top line or Sales number.
Let's visit the balance sheet again, this time to find the assets number on the left-hand
side of the balance sheet.
Just like with Equity, the convention is to take the average number of the starting and
ending balance of Assets for the year.
Once you have filled in these numbers into the equation, you can calculate
Return On Sales at 21%, Asset Turnover at .66, and Leverage at 2.66.
When you multiply these three components, you obviously get to the same 37% total ROE
number that we started with.
Having these numbers brings us back to the same question as before, at a more detailed
level: what is driving that performance?
Let's go from left to right through the three components.
21% Return On Sales sounds high, as my reference is delivering training at companies that have
a ROS in the 10% to 15% range.
We can drill down another level, and dive into the components of Return On Sales.
For that, we need a few more numbers from the income statement.
We already looked up Net Income and Sales, we will now also use Operating Income (or EBIT)
and Income before provision for income taxes (or EBT) in our calculations.
Let's fill in those numbers into the three sections that make up ROS.
Net Income over Earnings Before Taxes, which is called Tax Burden, is 75%, which means
that Apple's effective tax rate in 2017 is 25%.
Fairly low, but not unusual for a multinational company that is known
for optimizing its tax planning.
Earnings Before Taxes over Earning Before Interest and Taxes,
which is called Interest Burden, is 104%.
This is fairly unusual, as for most companies Earnings Before Taxes would be lower than
Earnings Before Interest and Taxes.
At Apple, the interest and dividend income is higher than the interest expense, therefore
Earnings Before Taxes is higher than Earnings Before Interest and Taxes.
Lastly, and this is where we get to the operational metric of EBIT margin,
EBIT over sales is 27%, which is high.
When you multiply these three components, you obviously get to the same 21% total ROS
number that we started with.
Zoom out from the ROS detail to the three step DuPont ROE formula.
The second component, Asset Turnover of .66, how does that stack up?
For 2016, I have looked into the Asset Turnover of two other well-known companies: telecom
and media company Verizon, and retailer Walmart.
The capital intensive Verizon has an Asset Turnover of .52, driven by the denominator
of Assets that includes huge numbers for Wireless Licenses, Plant, Property and Equipment, and
Goodwill.
Retailer Walmart has an Asset Turnover of 2.42, as asset velocity is the name of the
game in retail.
That leads us to the question: what is going on in Apple's Asset Turnover?
To answer that question, let's turn to the line items of the left-hand side of the balance sheet.
Apple has a huge amount of cash, as well as short term and long term marketable securities.
On average for 2017, the sum of those three is 253 billion dollar, or 73% of the total assets.
So what is dragging down the Asset Turnover ratio, is an unusually high number of financial assets,
rather than the operating assets of the company.
That brings us to the last of the three items: leverage.
2.66 is not an unusual number, but you can't really conclude much about this, as a potential
distribution of the financial assets to shareholders through dividends, as well as using the money
to pay down debt, would significantly impact both the numerator as well as the denominator
of the leverage equation.
Who knows what a "normalized" leverage ratio would look like for Apple!
I hope this video was useful both in understanding the math of the DuPont ROE formula, as well
as the interpretation of the numbers through DuPont analysis.
Thank you for watching!
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